Friday, January 13, 2017

The government must run a deficit

In my previous posts in describing the economy from a viewpoint of Modern Monetary Theory, I have stated that money only has value because it must be used to pay taxes. In this description, the government spends all "high-value" money into existence, and the banks leverage some of the surplus to create bank credit. This would seem to make the government the issuer of currency, and the banks users.

But actually it is the central bank that issues the currency, and the government is merely a user. The government can be thought of as a corporate entity with some special privileges. From an economics perspective it behaves like any company. It borrows money to spend, and it repays the loans from the revenues it generates. Rather than selling a product or service it has the power to take money from the economy in any manner it sees fit, but ultimately it's just a revenue. The only difference from a financial perspective is that corporate entities must pay back more money than they borrowed. The government does not have this requirement, and in fact it wouldn't be possible.

Let's look at how the money is circulated.

Lifecycle of fiat money

The lifecycle proceeds like this:

The central bank buys a bond from a borrower. The bank holds the bond, and in return the borrower gets money. The money didn't come from anywhere, it was just created. The bond has value because someone is legally obligated to repay it. The money has value because someone is willing to exchange good & services to repay the bond.

The borrower spends the money, and it goes into general circulation in the economy.

The borrower gathers money back out of the economy. Citizen borrowers do so by trading out goods & services in return for money. The government does so by simply taking it.

The money is returned to the central bank, and the money and the bond annihilate one another like matter and anti-matter.

Look at just the banks loans cycle. Because loans are always repaid with interest, the collections inflow will be larger than the capital outflow. By lending at interest the central bank removes money from the economy. Well where did that money come from? The only way it is possible is if the government is putting in more money that it is taking out. That is: it is running at a deficit. If the government ran a balanced budget, the banks would suck money out of the economy and cause deflation. Thus a balanced budget is actually a deficit where the government overspends by an amount equal to what is returned to it by the central bank. (The regional central banks return 6% of their profits to the banks and give the rest to the government.)

I'm not sure if the central bank refund is calculated into the federal budget or not. I assume it is, and I'll update here when I find out for sure.